Tuesday, 29 September 2009

More regulation in store for auditors?

The International Organisation of Securities Commission (IOSCO) Technical Committee has launched three related consultations on auditor transparency, communication and ownership structures.

Responding to concerns raised during the roundtable on the quality of public company audits in 2007, IOSCO launched three consultations reports on the transparency of audit firms and the effect this could have on the quality of audits and the availability and delivery of audit services; the adequacy of the standard audit report; and the impact of audit firm ownership structure on concentration in the market for auditing large issuers.

The first paper considers whether increased transparency about governance and indicators of audit quality by audit firms would provide the market with information necessary to create an environment where audit firms compete on audit quality.

This would also provide users of financial statements such as investors and audit committees information to make comparisons among audit firms and more informed decision-making, creating pressure for audit firms to raise audit quality.

Governance information such as how the firms’ network arrangements work, how quality control is implemented and monitored, human resource policies including how quality is linked to performance appraisal and ethics and independent practices would provide more insights into how audit firms are managed.

While the paper acknowledges the difficulty in defining audit quality, quality indicators such as experience and competency of professionals within firms, workload of the audit team and the percentage of senior engagement team spent time on an audit are input measures that contribute towards audit quality.

Disclosure of output measures such as firms’ involvements in disciplinary proceedings and restatement of audited financial statements are also being considered.

The second consultation paper explores the possibilities of enhancing the ways auditors report their opinions. The key concern on the existing way of reporting is that it has not changed to adequately reflect the growing complexity in business, financial reporting and auditing.

Apart from the binary nature of audit opinion and the use of boilerplate and technical language, the concern on the lack of robustness on the description of the auditors’ role in detecting fraud remains as a gap of the present reporting framework.

The options explored in improving audit reports are changing the organisational structure and the language of the standard audit report and incorporating additional communications to include matters such as other information in the annual report, association with interim information, internal accounting controls, corporate codes of conduct, and meetings with those charged with governance.

A more extreme option is to change the nature of assurance provided by auditors resulting in the consequential changes to the audit report.

The issue of audit concentration is addressed in the third consultation paper. The audit services for larger public companies are currently dominated by four large multinational networks of audit firms.

These four audit firms audited 98% of the 1,500 largest public companies in the US with annual revenues of more than US$1 billion (RM3.48 billion) in 2006 and 96% of the FTSE 250 companies in the UK as of February 2008.

As large public companies operate across many jurisdictions in many industries and engage in complex business arrangements, they seek audit firms that have the international breadth and specific industry expertise to satisfy the needs of their audits.

Ownership restriction has been identified as one of the critical factors that perpetuates the current state of concentration. Many jurisdictions require that audit firms be wholly or majority owned and controlled by practising licensed accounting professionals.

The paper notes that such practices restrict audit firms from accessing sources of ownership capital that could otherwise be used to create or develop firms capable of auditing the world’s largest companies and competing with the Big Four.

Allowing for non-practitioner ownership might enlarge the sophisticated pool of human capital with appropriate technical expertise, such as information technology, financial engineering, or legal services. This in turn could contribute to improvements in the quality of audit services and governance of audit firms.

There are both merits and risks in the present ownership rules applied across jurisdictions. It is argued that licensed public accountants carry higher public interest obligations and restricting ownership promotes the culture of professionalism.

The impact of an adverse judgment arising from a violation of professional standards could be greater for practitioners, increasing the deterrent effect of liability.

Audit firms are also observed to be managed by owner-practitioner boards and do not employ alternative governance structures, such as an independent board of directors.

It is noted that independent boards or management advisory boards, to the extent they have controlling voting rights, may help strengthen protections against conflicts of interest by maintaining the public interest perspective within the affairs of the firms.

The issues raised in the consultation documents would certainly inspire further debate in enhancing audit quality. At the same time implementation issues and cost factors should not be overlooked.

The last outcome that needs to be avoided is for any new rules resulting in further deterrent of the non-Big Four to scale up and compete effectively in the challenging auditing market.